Back to basics: brush up on the fundamentals of success

Custom Home, Nov-Dec, 2002 by Steve Maltzman

Whether you are in a hot market or a slow one, the end of the year is a good time to look at your business accounts to make sure you are taking care of the basics. In both up and down markets, a custom home business will run a lot smoother if you follow through on the basic activities I describe below.

Reporting Method. Many custom builders set their internal accounts up on a completed-contract basis, not recognizing revenue or costs from a job until the house is complete. Others use the cash method, only recording transactions when cash is received or disbursed. Still others use the accrual or billing method, which recognizes costs when invoices are received and revenue when draws are billed to the customer.

But the method that gives the best understanding of your company's financial results is the percentage-of-completion method of accounting. The percentage-of-completion method recognizes gross profit, cost, and revenue throughout the life of each contract based upon a periodic measurement of progress. This method is most desirable for pre-sold homes because it more accurately matches costs with revenues and, therefore, profit for a given period.

To see the differences between these accounting methods, consider the following example:

ABC Custom Builders just signed a contract for $500,000 to build a new house for Mr. and Mrs. Smith. ABC estimates total costs on the job to be $400,000. During the first month of the job, the following transactions occur:

* Cash of $10,000 is paid for permits, fees, and other start-up costs.

* An invoice is received from the excavation sub for $10,000.

* The first progress billing is prepared for $60,000.

If the above transactions were the only ones that ABC Custom Builders had for the month, its income statement under each method would look as follows:

Under the accrual method, revenue earned equals the amount that was invoiced on the first progress billing ($60,000). Revenue under the percentage-of-completion method is computed as follows:

By examining the four income statements you will see that the percentage-of-completion method best reflects the company's revenue, costs, and gross profit for the period. If the president of ABC Custom Builders received an accrual basis statement, he may think that the company is really prospering (the job is only 5% complete and they already made $40,000). However, this statement does not give a true picture of the company's profitability as of the end of the month. Since the job was only 5% complete, only 5% ($5,000) of the total projected gross profit ($100,000) has been earned.

The costs and revenues calculated in the percentage-of-completion method are the most accurate of the four but, at best, are still estimates of the true outcome of the job. To be a useful financial tool, this method requires that the job be accurately estimated using a job cost system that is up to date and easily comparable to the estimate.

Analyze Financial Reports. The IRS, bankers, and investors all require custom builders to record their financial data.

Most custom builders, however, do not realize that they can use this same financial information to help them improve the profitability of their businesses. Very few custom builders spend the time to learn what these statements are telling them. This is a big mistake because this information can show a custom builder where he's been and where he might be headed.

There are three basic management reports that you should review on a regular basis: the balance sheet, income statement, and job cost report.

The balance sheet is a statement showing the assets, liabilities, and equity of a business at a specific point in time. (Assets are those items that are owned by the business, while liabilities include items that the business owes. Equity is the owners' interest in the enterprise.) The balance sheet tells the business owner things like how much cash is in the bank, how much money is owed to the business and what the business owes, the cost of houses in process, and the worth of the business at that point in time. Comparing several balance sheets can reveal a company's structural changes and liquidity patterns.

Monitoring two key ratios in the balance sheet--the current ratio and the debt-to-equity ratio--on a regular basis will especially help to clarify a company's financial picture and identify problem areas before it is too late.

The current ratio is the most popular measure of a company's solvency. It compares the amount of current assets with which payments can be made to the amount of current liabilities requiring payment. A ratio of 1:3 is considered ideal. A lower ratio can be an indicator of future cash flow problems, while a ratio of more than 2:1 can indicate reluctance to use available credit. Here is the calculation:

Current Ratio = Current Assets/Current Liabilities

The debt-to-equity ratio measures the company's leverage ability. Banks strongly rely on this ratio to evaluate a company's credit worthiness. The higher the ratio, the more risk the creditor assumes. Conversely, a lower ratio usually indicates that the company has more borrowing capacity and greater long-term financial stability.